Understanding cost basis

First What is cost basis? Cost basis is, generally, the price you paid for your shares. This includes adjustments such as reinvested dividends and capital gains, as well as any sales commissions or transaction fees.

Why you need to calculate cost basis? Keeping track of your cost basis is an important step in determining your capital gains or losses on sales of shares. The IRS requires you to report your gains or losses for shares sold when you file your annual tax return.

Under provisions of the Emergency Economic Stabilization Act of 2008, the U.S. Treasury has issued new regulations that will require investment companies and brokers/dealers to begin reporting to the IRS the cost basis of securities you acquire in 2011 or later and subsequently sell or transfer.

The Act’s requirements apply to firms involved in the transaction: brokers, custodians, transfer agents, etc. Although the legislation does not address financial advisers’ role directly, the new regulations nonetheless will influence advisers’ workflow and change the reports their clients receive from custodians. 

The new rules phase in from January 1, 2011, through January 1, 2013, depending on the security’s type. Securities acquired before their class’s specified starting date are considered “uncovered” securities and brokers aren’t required to track cost basis for these securities. Securities acquired on or after their class’s specified date are “covered” securities and their basis and holding period must be tracked and reported. 

Timetable Cost Basis Legislation Change

What cost basis methods are available? 

The cost basis method you use can affect the capital gains or losses when you sell shares. In turn, it can also influence how much you owe in federal taxes. Therefore, it's important to give thoughtful consideration to your tax situation when choosing a method.

The following methods are approved by the IRS:

  • Average cost single category (ACSC)
  • First-in, first-out (FIFO)
  • Specific share identification
  • Average Cost - Double Category (ACDC

Average cost single category (ACSC)

Cost basis is calculated based on the average price paid for all shares held, regardless of holding period. Gains or losses are defined as short-term or long-term based on the assumption that the oldest shares are sold first, even though the average cost is the same for all shares. This method of calculating cost basis is permitted for mutual funds only and cannot be used to calculate cost basis for individual securities such as stocks and bonds.

Pros to use average cost

  • Simple to use. If your focus is on simplicity, the average cost method is easy to understand. It's automated, so you don't have to choose which shares to sell.
  • Less recordkeeping. You don't need to keep detailed records of all your share acquisitions and sales.

Cons to use average cost

  • Less control. Since you're not choosing which shares to sell, your gains or losses are spread evenly across all shares you own.
  • May be less tax-efficient than other methods. This may not be the best choice if you're concerned about minimizing your taxable gains or maximizing tax losses to offset gains. You have no control over the gains or losses that are realized by a sale.

First-in, first-out (FIFO)

This method assumes that the first shares you acquired will be the first ones we sell. This method is available for mutual funds, stocks, and ETFs

Pros to use FIFO

  • Simple to use. The principle behind FIFO—shares are sold in the same order they're acquired—is very easy to understand.
  • You can be hands-off. You don't need to choose which shares to sell; we'll automatically sell your oldest shares first.

Cons to use FIFO

  • May be less tax-efficient than other methods. Because shares to be sold are selected automatically based on acquisition date, this method may not be the best choice if you're concerned about minimizing your taxable gains or maximizing tax losses to offset gains. You have no control over the gains or losses that are realized by a sale.
  • Gains and losses are market-dependent. If the value of your shares has appreciated significantly because of market gains, you could end up with a large gain. Conversely, if the market has gone down, you could end up with a substantial loss.
  • May require more detailed recordkeeping. You'll need to have kept detailed records of all your acquisitions and sales of stocks (and certain ETFs) prior to January 1, 2011, and mutual funds prior to January 1, 2012.

Specific share identification

This method lets you identify which shares you are selling, giving you the most control over the amount of realized gains and losses. The IRS requires you to identify specific shares (or lots) to your broker/dealer at the time you sell them. You may identify specific shares for sales of individual securities when you submit the trade. You are not permitted to make the determination after the fact. This method is available for mutual funds, as well as stocks and ETFs.

Pros to use specific identification

  • More control. You get to choose the shares you want to sell for each transaction.
  • Potential for greater tax-efficiency. Specific identification makes sense if you're concerned about minimizing taxes. Based on the shares you select, you can manage the gain or loss that is realized on sales from your account.

Cons to use specific identification

  • Requires you to be hands-on. Unlike average cost and FIFO, this method isn't automated; you must choose the shares you want to sell.
  • May require more detailed recordkeeping. You'll need to have kept detailed records of all your acquisitions and sales of stocks (and certain ETFs) prior to January 1, 2011, and mutual funds prior to January 1, 2012.

Average Cost - Double Category (ACDC)

Cost basis is calculated on two average cost figures based on the holding period: one for short-term shares owned less than one year, and one for long-term shares owned more than one year. This method of calculating cost basis is permitted for mutual funds only; it cannot be used to calculate cost basis for individual securities such as stocks and bonds.